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Japan’s new policies and the threat of rising yields

A large rise in bond yields would threaten Japan’s sovereign solvency and banking system stability (view post here). New IMF econometric estimates suggest that the Bank of Japan’s quantitative and qualitative easing should lift yields just modestly, as rising inflation expectations would be offset by large public bond purchases. Meanwhile, the deteriorating fiscal trajectory could cause a 400bps rise in JGB (Japanese Government Bond) yields by 2030.

IMF Country Report No. 13/254, Japan: Selected Issues
The below are excerpts from the report. Cursive text and emphasis have been added.

The issue at stake

“A rise of long-term rates, if not accompanied by robust growth and inflation, is likely to pose an additional burden on fiscal conditions and financial stability given the high debt level and substantial holdings of JGBs in the financial system. A 100-basis-point rise in interest rates would boost the budget deficit by about ½ percent of GDP over five years according to Cabinet Office estimates (2010). Regional banks that hold a large portion of long-term JGBs may be subject to higher interest rate risks if yields spike. A 100-basis-point rise in the yield curve would pose interest rate risks equivalent to about 20 percent of the Tier 1 capital in regional banks.”

New econometric estimates of the drivers of long-term sovereign yields

“Countries in the panel estimation include Australia, Canada, France, Italy, Germany, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States. Euro area countries other than Germany (in some specification for robustness, France and Italy) are excluded as interest rates across euro area were aligned until the European debt crisis broke out. The sample period spans from 1990–2012 based on annual data.”

“Variables for external conditions include the current account balance and the net external balance (as percent of GDP). Fiscal variables include net government debt and/or, public assets as a percent of GDP as a stock variable and primary balance or cyclical fiscal balance (in percent of GDP) as a flow variable…[a] demographic factor measured by the (annualized) growth rate of the working-age population ratio. [Other variables are] real growth and inflation [and] the portion of sovereign bonds held by central banks, foreign official entities, or domestic private financial institutions depending on the specification.”

  • “Fiscal conditions are key contributing factors for long-term sovereign yields…For instance, a 1 percentage point rise of net government debt to GDP would increase the long-term yields by 2–4 basis points over the sample…Cyclical or primary balances, however, do not seem to exert statistical significant effects on long-term rates unless the specification uses gross debt terms and gross government assets. The stock of net public debt appears to be more influential in determining long-term interest rates.
  • External positions appear to affect long-term rates but are seldom statistically significant. This runs counter to the idea that Japan would run into a fiscal crisis when the current account turns into deficits. The estimates suggest that government debt may become unsustainable even when the current account stays in surplus if domestic savers refuse to finance the public debt at a low rate and shift their savings abroad. On the contrary, a fiscal crisis may not happen even when the current account turns to a deficit if that is driven by a strong direct investment inflows that lift up the growth potential.
  • The estimated coefficients for inflation expectations are strongly significant as expected and in many specifications the coefficients are not statistically different from one, consistent with economic theory.
  • Coefficients on real growth across specifications are statistically significant and have an expected positive sign.
  • A reduction in working-age population tends to reduce the long-term interest rates. The magnitude appears to be significant and large.
  • The composition of the investor base for government securities is important for long-term interest rates. Higher holdings by domestic entities tend to lower interest rates, but the cross-country estimates show that this reduction is mostly driven by central banks’ holdings rather than holdings by domestic financial institutions. Interest rates tend to go up instead if more public debt is held by financial institutions.”

What the estimates suggest for Japan’s long-term yields

“The estimates allow us to quantitatively assess to what extent each factor drives long-term rates over time under the QQME [Bank of Japan’s quantitative and qualitative easing] and rising public debts

  • The decomposition suggests low growth, disinflation, and aging of the population since mid-2000s have contributed to the low and stable long-term rates, which more than offset the impact of deterioration of fiscal conditions.
  • The sizeable purchases by the BoJ are likely to keep long-term rates lower by 70–150 basis points for the next few years under the QQME.
  • If the three-pronged strategy is able to exit deflation and lift growth, the long-term rates are likely to increase but at a modest pace.
  • The long-term interest rate, however, is likely to be dominated by the deteriorating fiscal conditions over the medium and long term based on current policies…Monetary policy alone cannot counter a potentially rising fiscal risk premium under current policies. Even if the BoJ expands its balance sheet to near 60 percent of GDP by 2014 under the QQME, the estimates indicate that long-term rates in Japan going forward are likely dominated by the deteriorating fiscal conditions”

“Long-term rates are expected to rise by 4 percentage points to near 5½ percent between 2012 and 2030, of which deterioration in fiscal conditions contributed to 3½ percentage points (about 3 percentage points from the projected rise of the net public debt ratio from 134 percent in 2012 to near 210 percent of GDP by 2030 and the large fiscal deficits account for ½ percentage points). Inflation and higher growth would add another 2 percentage points, while shrinking external surpluses contributed another ½ percentage points to nominal yields. The net increase, however, would be much smaller because of population aging (-1¼ percentage points), BoJ purchases (-¾ percentage points), and other factors.”

“Under an upside scenario with a full policy package, the long-term interest rates are likely to remain stable in the long run. In line with the model analysis in the staff report, the full policy package assumes credible fiscal policy adjustments and structural reforms that will achieve a declining public debt trajectory and higher potential growth.”


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